Wealth Management Research 19 February 2013

Education Note
Kathleen McNamara, CFA, CFP®, strategist, UBS FS

Interest rates and fixed income kathleen.mcnamara@ubs.com, +1 212 713 3310

Thomas McLoughlin, analyst, UBS FS

prices thomas.mcloughlin@ubs.com, +1 212 713 3914

Asset Class: Fixed Income

• Many investors focus on credit risk when they invest in fixed
rate bonds – the risk that an issuer may default on repaying the
Fig. 1: Interest rates and bond prices
principal and interest that it owes to the bondholder. Interest
rate risk is an equally important consideration. Interest rate risk
refers to the risk that interest rates might rise causing the value
of existing bond prices to fall.
When interest rates rise, bond When interest rates fall, bond
• Following a multi-decade period of declining bond yields, there prices fall prices rise
is now more room for yields to rise than there is for them
to fall. Because duration increases as interest rates decrease,
low coupon bonds are more price sensitive to interest rate
increases.
• Fixed income investments remain a core element of a Interest Price Interest Price
Rates
rates rate
comprehensive wealth management financial plan. That being
said, investors should be mindful of the sensitivity of bond
prices to changes in interest rates.

We are in a historically low interest rate environment Source: UBS WMR, as of 31 January 2013
In the aftermath of the global financial crisis of 2008, the Fed has kept
interest rates at historically low levels in order to help stabilize a badly
shaken financial system and stimulate a severely weakened economy.
Over the last four years, the Fed Funds rate - a key benchmark interest Fig. 2: Bond yields are influenced by the Fed's
rate that affects the rates for many fixed-income securities – has target rate
averaged just 0.145%. Over the prior 53 years, the rate had averaged yields, in %
5.67% and had never fallen below 1%. Before the 2008-2012 drop,
21
the last time rates fell precipitously was in the 2000-2003 period. 18
During that period, as the Fed sought to stimulate a weakened 15
economy, the Fed Funds rate fell from 6.24% to 1.13%. By 2007, 12
however, the rate had climbed back to just over 5% (See Fig. 2). 9
6
3
If interest rates go up, fixed-income prices will decline
0
When interest rates rise, the prices of most fixed-income securities fall. 1971 1978 1985 1992 1999 2006 2013
As a result, even in the absence of any substantial credit risk associated Fed funds target rate 10-year Treasury yield
with a particular security, fixed income investors still assume a certain
degree of price risk. In general, a bond will sell at or close to its par Source: Bloomberg, UBS WMR, as of 31 January 2013
value when the coupon rate equals the market interest rate. As the
market interest rate goes up, however, the coupon on existing bonds
will not provide investors as high a return as they could earn on newly-
issued fixed income instruments. As a result, prices of existing bonds
will sell below their par value to compensate prospective purchasers
for the less favorable coupon rate of those previously issued bonds.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures
that begin on page 5.
Education Note

All other factors being equal: 1) prices of longer-term bonds will be Fig. 3: Sensitivity of price return on fixed rate
more sensitive to interest rate changes than prices of shorter-term bonds over a one-year time horizon
bonds, and 2) prices of bonds with low coupons will be more sensitive 2.5% coupon, par priced, non-callable, in %
Declining yields Rising yields
to changes in interest rates than bonds with higher coupon bonds.
The most vulnerable securities, therefore, would be longer-term, zero- Maturity -50 bps -100 bps -150 bps No change +50 bps +100 bps +150 bps
coupon bonds. Of course, the larger the increase in interest rates, 5-year 1.9% 3.8% 5.8% unchanged -1.9% -3.7% -5.5%
the greater the adverse price impact on existing fixed-income instru-
10-year 4.1% 8.4% 12.8% unchanged -3.9% -7.6% -11.2%
ments.
20-year 7.9% 16.5% 25.9% unchanged -7.2% -13.8% -19.8%
What is duration risk? 30-year 11.0% 23.4% 37.6% unchanged -9.6% -18.1% -25.9%
The main gauge of a security's sensitivity to changes in interest rates
is its duration. This statistic is the weighted average maturity of a fixed Source: Bloomberg analytics, UBS WMR
income security's cash flows. For example, the current 10-year Trea-
sury note has a semiannual coupon of 2.00% and duration of 9.3
years. A zero coupon Treasury has a duration that is equal to its matu-
rity since all of the cash flows occur at maturity when the principal is Fig. 4: Sensitivity of price return on fixed rate
bonds over a one-year time horizon
paid. Mathematically, duration captures the percentage change in a 5.0% coupon, par priced, non-callable, in %
bond's price that would occur as a result of a 100bps or 1% change Declining yields Rising yields
in yield of the security. Because duration increases as interest rates
Maturity -50 bps -100 bps -150 bps No change +50 bps +100 bps +150 bps
decrease, low coupon bonds are more price sensitive to interest rate
increases. In general, the duration is greater the lower the coupon 5-year 1.8% 3.6% 5.5% unchanged -1.8% -3.5% -5.2%
and yield of the bond and the longer the maturity date. 10-year 3.7% 7.5% 11.5% unchanged -3.5% -6.9% -10.1%

20-year 6.3% 13.2% 20.7% unchanged -5.9% -11.3% -16.2%

The duration of the aggregate taxable fixed income market typically
fluctuates between 4 and 5 years, but the low yield environment has 30-year 8.0% 17.1% 27.2% unchanged -7.2% -13.7% -19.5%
pushed it over 5 years. Average duration varies in different segments
of the bonds market. For example, the Barclays US Aggregate Bond Source: Bloomberg analytics, UBS WMR
Index, which is often used as a standardized benchmark, now has an
average duration of 5.2. Meanwhile, the duration of a market index
of investment grade municipal securities is longer than most other Fig. 5: Sensitivity of price return on coupon bonds
fixed income segments at 6.6. versus zero coupon over a one-year time horizon
3.5% initial yield, non-callable, 30-year maturity, in %
Price sensitivity examples Declining yields Rising yields
In the accompanying table (Fig. 3), we gauge the price sensitivity on
Coupon -50 bps -100 bps -150 bps No change +50 bps +100 bps +150 bps
bonds with a 2.5% coupon and an initial price of par with various
maturity dates for the given changes in yields over a one-year time 3.50% 9.6% 20.5% 32.9% unchanged -8.6% -16.1% -22.8%

horizon, as some examples. 0.00% 19.3% 37.7% 58.9% 3.5%¹ -10.2% -22.1% -32.4%

At the 5-year maturity point, a 1% or 100bps increase in yield causes
the bond’s price to fall by 3.7%. Further out on the maturity spec-
trum, an increase in yield of the same magnitude (+100bps) would
result in a 7.6%, 13.8%, and 18.1% price decline at the 10-year, 20-
year, and 30-year maturity spots, respectively.
¹ Note: The 3.5% increase in price represents accretion on
the zero coupon bond. Source: Bloomberg analytics, UBS
WMR

In Fig. 4, we provide the same analysis as shown in the previous exam-

ple but use a higher constant coupon rate of 5% at various maturi-
ty points. In this instance, the price decline given a 1% or 100bps
increase in yield at the front part of the yield curve at the 5-year matu-
rity (-3.5%) is modestly lower than the price decline that would occur
with a 2.5% coupon (-3.7%). Meanwhile, longer-dated bonds exhibit
a more meaningful difference in the price decline (-13.7%) compared
to the figure shown in Fig. 3 for the lower coupon bonds. (-18.1%).
The higher coupon of the bonds has the effect of reducing the price
decline when all other factors are equal.

Wealth Management Research 19 February 2013 2

Education Note

Additionally, in Fig. 5, we illustrate how long-dated zero coupon Fig. 6: Sensitivity of price returns on fixed rate
bonds versus par-priced securities with the same maturity date would bonds given a +150bps yield increase over a one-
respond to various interest rate changes. As discussed above, zero year time horizon
in %
coupon bonds are the most sensitive to yield changes since all of the
cash flow is paid at maturity, therefore, its duration is equal to its Maturity
maturity date. In the example, at the end of one-year, a 1% or 100bps Coupon 5-year 10-year 20-year 30-year
increase in yield would cause the price on a 30-year zero coupon bond
with an initial yield of 3.5% to fall by over 20%, while a coupon pay- 2.0% -5.6% -11.5% -20.7% -27.2%
ing bond's price would decline by about 16.0%. 3.0% -5.4% -11.0% -19.0% -24.2%
Finally, the table in Fig. 6 depicts the price return of bonds with various 4.0% -5.3% -10.5% -17.6% -21.6%
coupon rates and maturity terms assuming a 150bps increase in yields 5.0% -5.2% -10.1% -16.2% -19.5%
and a one-year time horizon. Bonds with the shortest maturity term
and highest coupon rate (5.0% 5-year maturity) will experience the Note: analysis assumes bonds are initially priced at par and
smallest price decline (-5.2%). By contrast, the longest dated, lowest are non-callable. Source: Bloomberg analytics, UBS WMR
coupon bonds (2.00% 30-year maturity) will undergo the largest price
decrease (-27.2%).

Note that the tables in Fig. 3 through Fig. 6 reflect price change
only and do not consider the coupon income received on the bonds.
An investor's total return on interest bearing bonds will differ. (Total
return = coupon income + income from reinvested coupons + price
change.)

Talking total return

In the previous examples we illustrated the effects of changing interest
rates on bonds solely on a price return basis for investors focused on
price volatility. We now explain the other main component of return
on a bond which is income, and combine it with price return. Gen-
erally, buy and hold investors focus on the income that fixed income
investments generate over the life of the bonds and are not concerned
with the price path the bond follows along the way. Meanwhile, oth-
er investors that seek to balance portfolios more frequently focus on
total return.

The total return (income + income from reinvested coupons + price

change) for a given change in yield is roughly equal to the price return
shown in the tables in Fig. 3 through Fig.6 plus the bond’s coupon
rate. For example, in Fig. 3, we show the price change on a 2.5%
coupon bond, initially priced at par, with a 10-year maturity, given a
+150bps increase in yield over a one-year time horizon produces a
-11.2% decline in price. The total return on the bond would be that
price change (-11.2%) plus the 2.5% coupon rate to approximately
equal -8.7%. Note that over short-time horizons, such as one-year
considered in our example, the reinvestment of coupon interest does
not have a material impact on total return. By contrast, when coupon
interest is reinvested over long-time periods the effect would be more
meaningful. During rising rates the coupon interest can be reinvested
at higher reinvestment rates having a positive effect of boosting total
returns.

When the yield curve is upward sloping, longer-dated maturities typ-

ically have higher yields compensating investors for a portion of the
additional price risk.

An inverse relationship
The inverse relationship between interest rates and price is not lim-
ited to corporate or municipal bonds. In fact, it tends to be most

Wealth Management Research 19 February 2013 3

Education Note

pronounced in Treasuries and other obligations backed by the full

faith and credit of the United States government. The inverse rela-
tionship extends to emerging market debt, certain structured notes,
mortgage-backed securities, real estate investment trusts, preferred
securities, and funds that invest in fixed-income instruments - includ-
ing both open-end and closed-end mutual funds and exchange trad-
ed funds. The price of virtually any instrument whose value is depen-
dent on fixed periodic payments is inversely related to interest rates
because those payments are not worth as much when there are newly
issued fixed-income securities that pay more. Also, leveraged closed
end funds (CEFs) are more sensitive to changes in interest rates than
non-leveraged funds. Rising rates affect leveraged CEFs in two ways.
First, as bond prices decline the underlying net asset value of the funds
falls. Second, the funds’ leverage costs increase and earnings corre-
spondingly decline, all else being equal.

Liquidity considerations
In general, with the exception of US Treasury obligations, the sec-
ondary market for fixed-income securities is less liquid than the sec-
ondary market for equity securities. Liquidity refers to the speed and
ease with which an asset can be bought or sold in the secondary mar-
ket. For example, with USD 11 trillion in marketable debt outstand-
ing, the US Treasury market is considered one of the most liquid in the
world. However, the US high yield corporate bond market has about
USD 1 trillion outstanding and is prone to bouts of illiquidity during
periods of acute market stress. Municipal bond liquidity also can vary
depending upon the underlying rating and the degree to which a par-
ticular borrower is well-known to investors.

Liquidity risk is exacerbated if order flow becomes imbalanced. When Fig. 7: Dealer inventories of corporate bonds have
investors seek to liquidate positions en masse, there may be longer declined
delays and transaction costs associated with the sale of securities. An Primary dealer corporate inventory with maturities over
“illiquidity premium” may arise when price concessions are demand- one year, USD, in mn
ed in order to satisfy a buyer’s demand. Additionally, the liquidity for
fixed-income securities has declined in recent years as global financial 250,000
services firms have gone through a deleveraging process and reduced 200,000
the size of their balance sheets. This has resulted in a reduction in
corporate bond inventory among primary dealers and lower trading 150,000
volumes relative to the pre-crisis years (See Fig. 7). Liquidity is gener-
100,000
ally not an issue for investors who buy and hold individual bonds until
maturity. 50,000

0
Diversifying your fixed income portfolio
2002 2004 2006 2008 2010 2012
The right combination of fixed income securities is an important com-
ponent of a diversified portfolio across different interest rate environ- Source: Bloomberg, UBS WMR, as of 16 January 2013
ments and should be discussed with your personal financial advisor.
This education note is designed to remind investors of the basic rela-
tionship between interest rates and bond prices.

Wealth Management Research 19 February 2013 4

Education Note

Appendix

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Wealth Management Research 19 February 2013 5